What is an FHA 203(k) Rehab Loan?

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Karl Pierre bought his first house in 2009, in Stony Brook, New York. When he moved in, he went to live in the basement — for a very good reason. 

Pierre wasn’t your typical first-time home buyer; he wanted to “hack” his house. “House hacking” simply means buying a property and taking in renters to help make it affordable. For Pierre, that meant living in the basement and renting out the upstairs bedrooms to local college students to cover the cost of his mortgage — and then some.

And the reason he was able to buy and renovate the house was a 203(k) rehabilitation loan from the Federal Housing Administration (FHA). 

“It’s something I highly recommend,” Pierre says, “because it is the lowest cost to enter a real estate transaction,” except for zero-down-payment loans from the Veterans Administration. 

Getting an FHA 203(k) rehab loan was definitely significant in laying the foundation for me,” adds Pierre, who is now a real estate investor and educator.

FHA 203(k) rehab loans may not be the most popular home loans around, but they are a very effective option for buyers interested in fixer-uppers but lacking the funds to make the necessary repairs or improvements. 

This type of mortgage allows you to finance in a single loan the home itself and the renovation costs. You can also use an FHA 203(k) rehab loan to refinance and renovate a home you already live in.

“For people who want a little bit more control over high-ticket replacement items, like a boiler or a roof, they can bundle that into their initial loan and have some peace of mind and live in a home that appeals to their aesthetic desires,” Pierre says. 

If you plan to purchase a fixer-upper or need to make improvements to your existing home, here’s everything you need to know about an FHA 203(k) rehab loan.

How an FHA 203(k) Rehab Loan Works

The biggest benefit of an FHA 203(k) rehab loan is having the ability to wrap the purchase price and the renovation costs all into one loan with a competitive interest rate. That means you don’t have to pay for remodeling costs out of pocket.

“A 203(k) loan is specifically for a property that is distressed or going to be improved. This is not for people who are afraid of paying mortgage insurance, or for people who just want a turnkey property,” Pierre says. 

But this type of mortgage comes with a lot of paperwork, a longer timeline, and a larger chance of things not going as planned during the process.

 “Part of why the 203(k) isn’t super popular is it is pretty complex and it can be kind of frustrating for people to go through,” says Kyle Seagraves, a mortgage broker and educator in Dayton, Ohio.

If you’re considering an FHA 203(k) loan, you should know there are two versions: the standard 203k and the more popular limited 203(k). 

The standard 203(k) version allows for repairs which can include major structural changes and repairs in excess of $35,000, whereas the limited 203(k) version is ideal for minor home improvements costing less than $35,000. To qualify for the standard 203(k) loan, the renovation costs must be greater than $5,000. 

With an FHA 203(k) loan, you can borrow up to 110% of the home’s expected market value once all the repairs are complete, or the home price plus renovation costs, whichever is less. 

The total loan amount can’t be higher than the FHA mortgage limits for your county, up to the  nationwide FHA loan limit. For 2020, that limit is $331,760 in low-cost areas and $765,600 in expensive markets.

An FHA 203(k) loan can be a 15- or 30-year fixed-rate  or adjustable-rate mortgage, from a lender approved by the U.S. Department of Housing and Urban Development (HUD). 

FHA 203(k) loans, however, often have higher interest rates than standard FHA loans because they’re considered higher-risk mortgages, says Seagraves. Still, mortgage rates in general remain very low, since the Federal Reserve is keeping its Federal Funds Rate at near-zero to support the economy amid the coronavirus pandemic. As of Nov. 10, the average 30-year fixed mortgage rate is 2.78%, according to Freddie Mac. (You can stay up to date on current mortgage rates with NextAdvisor’s rate tracker.)

You’ll also have to pay FHA mortgage insurance. An upfront mortgage insurance premium costs 1.75% of the full loan amount and can usually be rolled into the loan. Monthly mortgage insurance premium amounts range between 0.45% to 1.05% of the loan amount, but are ultimately determined by the loan term, the size of the down payment, and how much you’re borrowing. 

This FHA mortgage calculator can help you estimate your monthly mortgage payment, your taxes, and insurance costs.

Requirements To Qualify

A 203(k) rehab loan isn’t for everyone. It’s mostly meant to help those who want to finance a home and repair costs together, but might not otherwise qualify for a typical construction loan. 

Many purchase a home first and then refinance the rehab costs on top of it, but it can be difficult to get a loan solely for rehab costs, Seagraves says. “Lenders typically don’t want to give money out for rehabs because technically it’s unsecured, unless it’s tied in with a loan like a 203(k),” Seagraves says.

FHA loans are known for their flexibility when it comes to down payment amount and the minimum credit score needed to qualify.

The FHA typically allows borrowers to have credit scores as low as to 580, but many FHA-approved lenders have tightened their lending standards over the last few months due to the pandemic. That means they are looking for minimum credit scores  in the mid-to-high 600s.

The FHA requires just a 3.5% down payment, but that percentage is based on both the sale price and total repair costs. Your lender will ask you to disclose your income as well as your overall debt during the loan application process; the maximum level allowed of debt versus income for FHA loans is 45%, but some lenders may allow more.

Another important requirement: You have to live in the property you are buying within 60 days of closing. You can buy a single-family home, up to a maximum of a four-unit building, and “house hack” like Pierre did, or a condominium, as long as it’s approved by the FHA. The FHA-approved condo lookup tool can help you figure out whether a specific condo qualifies for an FHA loan.

What Repairs Qualify for 203(k) Financing?

Before you apply for this loan, you should be aware of which repairs qualify for 203(k) financing. You can’t add luxury amenities like a tennis court or swimming pool, and the project has to be finished in six months or less.

Here are some examples of home improvements that you can finance with a 203(k) rehab loan, according to HUD:

  • Any room additions
  • Bathrooms or kitchen upgrades, including new built-in appliances
  • New roof, flooring, windows, and doors
  • Energy-efficient upgrades
  • Plumbing, heating, air conditioning, and electrical upgrades
  • Weather stripping and insulation upgrades
  • Disability improvement
  • Completing a basement or attic conversion or adding a second story
  • Expanding or building a garage or carport
  • Renovating a deteriorating property with structural problems or termite damage
  • Adding a porch, deck, or patio
  • Adding or repairing siding, or repainting
  • Landscape improvements
  • Removal of health and safety hazards, such as lead-based paint

How to Buy a House with an FHA 203(k) Rehab Loan in 7 Steps

The process for an FHA 203k loan is like that of regular homebuying, but with more moving parts and extra people involved.

“It’s a dance of nine or 10 people.” Pierre says. That includes the buyer, the seller, the lender, real estate agents, a contractor (or more in some cases), an appraiser, a home inspector, and possibly a HUD consultant (if repairs are more than $35,000). 

1. Find a Lender Who Offers FHA 203(k) Rehab Loans

It’s always smart to shop around and talk to multiple lenders to compare different rates and fees. Start by using the HUD’s lender search list tool to find lenders that offer FHA 203(k) rehab loans.

Keep in mind that not every FHA-approved lender offers 203(k) rehab loans. 

“Since we were just coming out of the Great Recession, it took me 20 calls to even find a processor who did these loans,” Pierre says of his search in 2009. “But nowadays they’re used with greater frequency, so people shouldn’t have so much trouble finding them.”

2. Get Preapproved

Just like any other kind of mortgage, you’ll need to get preapproved before you can move forward with the homebuying process. Read NextAdvisor’s take on how to get preapproved for a mortgage

3. Go House Hunting

Finding a home that’s eligible for a 203(k) loan is not as hard as it seems.

Many people assume that the only eligible properties are those that went through a foreclosure or short sale and have damage. But that’s not the case. As long as the property is at least one year old and has fewer than four units, it is eligible for a 203(k) loan. 

A 203(k) loan can also sidestep the normal FHA requirement that a home be move-in ready for a loan to be issued. “203(k) allows you to take a home that’s not move-in ready,” Seagraves says.

This program is not designed for investors to make a quick profit, but if you’d like to renovate a multiple-unit property, you can still qualify for it as long as you live in one of the units. 

4. Choose Your Projects and Contractor

If your repairs will cost more than $35,000, a HUD consultant will work with you to decide what parts of the home need improvement. 

The lender will require any safety or health hazards to be addressed first – things like mold, broken windows, lead-based paint, and missing handrails.

You and the HUD consultant will work together to figure out which structural and cosmetic parts of the home you’d like to renovate. For example, you’re allowed to replace appliances, add granite in the kitchen, or gut the bathroom, and include those costs in the loan.

You’ll be responsible for finding a licensed general contractor, possibly multiple contractors, which is a critical part of the process. Talk to  your realtor, HUD consultant, and other experts involved to find a reliable and trustworthy 203(k) contractor. 

“One of the most important parts is finding a contractor who understands what is happening, meaning the loans are designed so that the work is front loaded. So the contractor has to have enough liquidity to pay for their team, pay for materials, and trust that the rest of the money is in escrow to pay for the renovations. A lot of contractors aren’t quite comfortable with that,” Pierre says.

5. Get Estimates For the Repairs

The contractor of your choosing will create a detailed bid document of all repairs. It’s essentially a breakdown of cost estimates for all the proposed renovation work.

Once that’s complete, you and the lender get a copy of the bid document.

An appraisal comes next, and a final bid is used by the appraiser to determine the future value of home once all renovations are complete. For example, Pierre purchased his home for $300,000 and it had an after-repair value of $450,000.

6. Close The Loan

The lender submits the bid, appraisal, and all the buyer’s financial information (income, credit history, preapproval letter, assets, etc.) to underwriting.

Once the underwriter has finalized the loan documents, the buyer can sign them.

“I would say a 203(k) loan adds about 30 days to the process,” Pierre says. “Most people close in about 45 days. It took me about 90 days to close, and the repairs took about 12 weeks.”

7. Complete Repairs and Move In

The lender will fund the contractor half the loan before construction starts. The other half is put into an escrow account, and will be paid only after all the renovations are complete — which gives the contractor enough money to start, and is encouraged to see the work through.

After the loan is secured, the contractor can start the home improvements. Depending on the condition of the home and extent of the renovations, you may be able to move in at the same time.

The contractor has six months to finish the home renovations and repairs. For larger projects, you may have to arrange to live somewhere else until work is done. According to the 203(k) guidelines, you’re allowed to add up to six months of mortgage payments to your loan amount to cover your living costs during the construction period. 

Once the repairs are completed, it’s time to move into your new home.